Report of the Committee on Clearing Corporations

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1 Report of the Committee on Clearing Corporations Securities and Exchange Board of India July 2015

2 Letter of Transmittal Shri U K Sinha Chairman Securities and Exchange Board of India Mumbai 17 July, 2015 Dear Sir Report of the Committee on Clearing Corporations We have great pleasure in submitting the Report of the Committee on Clearing Corporations set up by SEBI. We sincerely thank you for entrusting us with this task of contemporary relevance. Yours faithfully, ii

3 Acknowledgements This report of the Committee on Clearing Corporations has been made possible with the support and contributions of many individuals. The Committee would like to gratefully acknowledge their significant efforts and contributions. The Committee sincerely thank for the valuable support provided by Chief General Manager Shri Pramod Kumar Bindlish. The Committee places on record its deep sense of appreciation for the exemplary dedication and enormous efforts put in by the core team from the Market Regulation Department comprising Shri Shashi Kumar Valsakumar, GM, Ms. Maninder Cheema, DGM, Ms. Yogita Jadhav, Shri Peter Mardi, Shri Meetesh Patel, Shri Atul Mittal and Shri Ramaneesh Goyal in providing comprehensive research and secretarial assistance, for conduct of meetings of the Committee, preparing materials for discussion and compiling draft materials. i

4 Abbreviations CC - Clearing Corporation CCP-Central Counter Party CSD- Central Securities Depository CCIL- Clearing Corporation of India Ltd. CPMI - Committee on Payment and Market Infrastructure CM - Clearing Member DSRC-Depository Systems Review Committee EMIR - European Market Infrastructure Regulation ESMA - European Securities and Markets Authority EU- European Union FMI - Financial Market Infrastructures ICCL - Indian Clearing Corporation Ltd IOSCO - International Organization of Securities Commissions MSEI (formerly MCX-SX)-Metropolitan Stock Exchange of India MCX-SXCCL - MCX-SX Clearing Corporation Ltd. MII- Market Infrastructure Institution NSCCL - National Securities Clearing Corporation Ltd PFMI - Principle for Financial Market Infrastructure RBI - Reserve Bank of India ii

5 SE - Stock Exchange SEBI - Securities and Exchange Board of India SECC - Stock Exchange and Clearing Corporation Regulations 2012 SCRA - Securities Contract (Regulation) Act 1956 SGF-Settlement Guarantee Fund USA - United States of America iii

6 Executive Summary The Securities and Exchange Board of India (hereinafter referred as 'SEBI') constituted a Committee, under the Chairmanship of Shri. K V Kamath, to examine the viability of introducing a single clearing corporation (CC) or interoperability between different CCs, as well as issues pertaining to investments, calculation of liquid assets in Net worth of recognised CC and Transfer of Profits by recognised SEs to the fund of recognized CC s. The Committee deliberated extensively on the various terms of reference and while framing its recommendations has taken into account the present Indian securities market eco-system, the views expressed by different stakeholders and the global experience with regard to Clearing Corporations. On the issue of viability of introducing a single clearing corporation or interoperability between different CCs, the Committee has recommended that at this juncture, moving to a single CC may not be appropriate for the securities market. Preserving the current market structure and maintaining separate clearing corporations for each exchange would be prudent at this stage. However, SEBI may keep the interoperability option open and consider the proposal for implementation when ground conditions are met, which, inter alia, include clear intent of the participants coming together and having a suitable framework in place to the satisfaction of SEBI. On the issue of investment by a recognized CC and the manner of utilization of profits of CCs, the Committee has recommended that the investment policy of a CC should be built on the premise of highest degree of safety and least market risk. The Committee recommends that CC may be permitted to invest in Fixed Deposits (FDs) / Central Government Securities (G Secs). Other instruments like Non-Convertible Debentures (NCDs), Commercial Papers (CPs), money market mutual funds etc. may not be permitted iv

7 as investment vehicle as they carry credit/liquidity risks. The investment policy may be reviewed at least on an annual basis by the CC. On the issue of reviewing the existing regulation of transfer of profits every year by the recognized Stock Exchanges to the fund of recognized CC, the Committee has recommended that since the requirement of core Settlement Guarantee Fund (SGF) has already been met, the 25% profit transfer requirement might not be required. Also, the Risk Management Review Committee (RMRC) of SEBI may review the stress test model, used to determine the Minimum Required Corpus (MRC) of core SGF, for making such departure. With regard to the contribution already set aside by the Stock Exchanges towards the 25% profit transfer requirement, the Committee has recommended that the same may be utilized by exchange to cover the member contribution to the core SGF since this would result in lower transaction costs and would be in the overall interest of the market. SEBI may specify the details in this regard including in respect of contributions already made by CCs on behalf of members. Further, the requirement of member contribution may be reviewed after 5 years, or earlier, if warranted. The Committee recommended that SEBI may specify the details in this regard and may appropriately make necessary amendments to the SECC Regulations On the issue of transfer of Depositories profits to their Investor Protection Fund (IPF), the Committee recommended that depositories may transfer 5%, or such percentage as may be prescribed by SEBI from time to time, of their profits from depository operations every year to the IPF since the date of amendment of SEBI (Depositories and Participants) (Amendment) Regulations, 2012 requiring transfer of profits. SEBI may consider necessary amendment to SEBI (Depositories and Participants) Regulations, 1996 to enable the same. v

8 The percentage of profits to be transferred every year by depositories to the IPF may be reviewed by SEBI on a periodic basis. On the issue of defining the liquid assets of CCs for the purpose of calculation of Net worth of a clearing corporation, the Committee recommended that the liquid assets should comprise Fixed Deposits (FDs)/Central Government Securities (G Secs). Further, other instruments like NCDs, CPs, money market mutual funds etc. carry credit/liquidity risks and hence, may not be considered towards calculation of liquid assets in net worth of CC. vi

9 Table of Contents Chapter Content Page 1 Background Methodology Introduction Viability of introducing a single Clearing Corporation (CC) or interoperability between different CCs Investment Policy of Clearing Corporations Transfer of 25% profits of stock exchanges to the Settlement Guarantee Fund of Clearing Corporation Transfer of 25% profits of Depositories to their Investor Protection Fund(IPF) 7 Liquid assets for calculation of Net worth of Clearing Corporation vii

10 CHAPTER 1 Background The Securities and Exchange Board of India (hereinafter referred as 'SEBI') constituted a Committee under the Chairmanship of Shri. K. V. Kamath, to examine the viability of introducing a single clearing corporation or interoperability between different CCs, as well as pertaining to Investments, calculation of liquid assets in Net worth and Transfer of Profits of recognised CCs. The other members of the Committee were: a. *Shri. G Padmanabhan- Executive Director -RBI b. **Ms. Nanda Dave-Chief General Manager-RBI c. Prof. V. Ravi Anshuman, Professor, Finance and Control, IIM Bangalore d. Prof. Deepak B. Phatak- Professor, IIT Mumbai e. Prof. B. Sambamurthy-Ex Director, Institute for Development and Research in Banking Technology(IBRDT) f. Shri S. V. Murali Dhar Rao, Executive Director, SEBI (Member Secretary). * Shri G Padmanabhan Executive Director-RBI stepped down as Member of Committee upon attaining Superannuation. **Ms. Nanda Dave CGM-RBI was nominated as Member of Committee in place of Shri G Padmanabhan-Executive Director-RBI. Under the terms of reference, the Committee needed to review and make recommendations on the following issues: a. The viability of introducing a single Clearing Corporation (CC) or interoperability between different CCs. b. Investment by a recognized CC and the manner of utilization of profits of CCs. 1

11 c. To examine and review the existing regulation of transfer of profits every year by the recognized Stock Exchanges to the fund of recognized CC. d. To define the liquid assets of CCs for the purpose of calculation of Net worth of a clearing corporation. Any other matter that Committee considers relevant or incidental thereto. Accordingly, the issue of Transfer of Depositories profits to their Investor Protection Fund (IPF) was referred to the Committee. 2

12 CHAPTER 2 Methodology The Committee was apprised of the evolution of the Clearing Corporations in Indian securities market and the steps taken by SEBI in order to develop the Indian securities market eco-system, especially by delineating the Clearing Corporations from the Stock Exchanges and defining the role and responsibilities of the Clearing Corporation. The Committee examined the international practices with regard Interoperability of Clearing Corporations. Further, to facilitate the deliberations of the Committee an approach paper was prepared by SEBI on - the 'European Experience on Interoperability', the present structure of Indian Markets and risk management framework and the risks arising out of interoperability/ Single Clearing Corporation. The Committee also took note of the international standards - Principles of Financial Market Infrastructures (PFMI), published by the Committee on Payment and Market Infrastructure (CPMI) and International Organization of Securities Commissions (IOSCO) on the regulation, supervision and monitoring of the payment and settlement systems, record keeping agencies etc. which play an important role in supporting and strengthening the global financial system so that it can withstand shocks. Subsequently, this committee also held discussions with representative of the three Clearing Corporations - Indian Clearing Corporation Ltd, MCX-SX Clearing Corporation Ltd. and National Securities Clearing Corporation Ltd. Further, the committee also met representatives from ICICI Securities, National Securities Depository Ltd, DSP Merill Lynch, Forum Trading Solution and Clearing Corporation of India Ltd. 3

13 This report brings out the recommendations of the Committee. The committee, while framing its recommendations has taken into account the present Indian securities market eco-system, the views expressed by different stakeholders and the global experience with regard to Clearing Corporations. 4

14 Evolution of the Securities Market CHAPTER 3 Introduction Advancement in technology has had a significant impact on the global securities market. Rapid adoption of such technology has enabled investors, spread across different geographies to trade in several classes of assets in a matter of milliseconds. The journey from an open-outcry trading system to an online screen based trading mechanism available today has been challenging but such systems have benefited all the stakeholders in the securities market by reducing costs and increasing efficiency. This momentous increase in trading and the resultant importance of market infrastructure has caused the regulators around the world to relook at the Risk Management and Clearing and Settlement Mechanism in place. The Indian Securities Market also witnessed a transformation, wherein, the importance of institutions engaged in providing clearing and settlement services was recognised. Towards this end SEBI constituted a Committee on "Review of Ownership and Governance of Market Infrastructure Institutions" under the Chairmanship of Dr. Bimal Jalan, (Former Governor, Reserve Bank of India), to examine the issues arising from the ownership and governance of Market Infrastructure Institutions (MIIs). Based on the recommendations of this committee SEBI framed the Securities Contracts (Regulation) (Stock Exchanges and Clearing Corporations) Regulations, 2012 published on June 20, 2012 (hereinafter referred to as 'SECC Regulations'). The SECC Regulations provided the broad framework for regulation, supervision and monitoring of the Stock Exchanges and Clearing Corporations. 5

15 In light of the SECC Regulations, SEBI recognized three Clearing Corporations - Indian Clearing Corporation Ltd. (hereinafter referred to as 'ICCL'), National Securities Clearing Corporation Ltd (hereinafter referred to as 'NSCCL') and MCX-SX Clearing Corporation ltd. (hereinafter referred to as 'MCX-SXCCL') to clear and settle for their respective Exchanges. Further, the CPMI and IOSCO also prescribed international standards (PFMIs) for systemically important financial market Infrastructures including Clearing Corporations, so as to strengthen such institutions which can support the global financial markets. 28 Jurisdictions have committed to adopt the PFMIs in their regulatory and supervisory functions over the systemically important financial market infrastructures. The process flow of the current clearing and settlement in the Indian Securities Market is highlighted below Funds (Cheque) Securities (DIS) C 1 Buy order Broker - 1 Broker -2 EOD File T 1 O 1 O 2 Stock Exchange T 1 EOD File Sell order Securities (DIS) Funds (Cheque) Clearing Bank EOD File T 1 Clearing Corporation Depository Br-1 A/c Br -2 A/c A/c with CB A/c with Dep Collate Margins Blocked Br ral for Br 1 Margin 2 Br 1 A/c Br 2 A/c 6

16 Note - C1 Client O1 Order T1 - Trade EOD End of Day Br Broker a) As soon as an order (O1) is placed by the broker, and the same converts into a trade (T1) a measure of risk is introduced into the system. The trades are then transferred to the Clearing Corporation (CC) for clearing and settlement requirements. The CC acting as a central counter party assumes the risk of settlement of the trade. b) The risk that the CC faces is from the clearing member defaulting on the pay-in obligations at the time of settlement. c) In order to capture this risk, a mechanism of collateral based margining has been put in place. This mechanism seeks to block a certain percentage of the collateral, calculated as a measure of volatility, based on the value of the trade. d) Further, the members are required to bring additional margins in order to cover the change in price of the scrip from the day of trade till the day of final settlement. e) In case of default by the clearing member, the CC steps in and makes good the settlement and conducts the necessary processes to recover the monies from the defaulting member. 7

17 CHAPTER 4 Viability of introducing a single Clearing Corporation (CC) or interoperability between different CCs 4.1. Background Clearing Corporations have been a fundamental constituent of the securities market for decades. Evolution of regulations has allowed for the entry and exit of market infrastructure intermediaries, thus changing the capital market landscape. There is an increased level of competition at the level of various market infrastructure intermediaries, such as exchanges, clearing corporations and depositories. The genesis of a single clearing corporation or interoperability between existing clearing corporations stems from the current suboptimal utilization of capital, wherein, margins, need to be deployed at the individual clearing corporations by market participants even if transactions are offsetting in nature till the time pay-ins are made. Further, the lack of flexibility for the market participants in choosing the venue for the clearing and settlement services results in higher cost to the market participant. Propagators of Interoperability of CCs highlight that interoperability gives the trading members the option to clear trades with the clearing corporation of their choice. In the Indian context for e.g.: An investor could trade on, say BSE Ltd, and get the trade cleared through the Clearing Corporation of the National Stock Exchange, or vice versa which would result in efficient use of capital for trading members who take positions on multiple stock exchanges. Some of these positions may be offsetting in nature and would hence result in a much lower outgo on margins and collateral. Additionally, when 8

18 clearing corporations aren t linked to just one exchange but offer clearing services to other venues as well, competition among trading venues is enhanced. Propagators of single Clearing Corporation highlight that while participants could always compete on the front end of the securities business, there are considerable cost efficiencies and risk reduction advantages to commoditising back office functions of a centralized infrastructure model that could achieve economies of scale by centralized trade netting, reducing cost and risk. Interoperability is mainly a European initiative due to the fragmented market structure in Europe with more than 11 CCs operating in the European markets. To date, interoperability has predominantly been a European phenomenon, reflecting an effort in the European Union (EU) to foster a more integrated financial market. Market participants and regulators have encouraged interoperability as a way of lowering the costs to participants in accessing the markets served by CCs across EU countries, which otherwise often required the use of multiple nationally oriented intermediaries. Presently, interoperability is applicable only for cash markets. Both in Europe as well as in the USA, trading happens through multiple trading facilities (called Multilateral Trading Facilities in Europe and Alternate Trading Systems in the USA) which are essentially brokerage firms which provide trade execution facility and operate as deemed exchanges with independent clearing arrangements. Globally, the facility of interoperability is not available for derivatives as derivatives are created by an Exchange with specific trading, risk management and clearing features and hence such products are traded and cleared only on the respective Exchange. The European experience helps to illustrate the forces that led to the implementation of the existing links, and some of the impediments to their establishment. As per 9

19 reports, pursuant to interoperability arrangements the increased rivalry triggered has proven to be beneficial with up front clearing fees falling by up to 80% during the past two years ( ), according to industry reports. In addition, Euro CC, LCH Clearnet, Six Securities Services; and EMCF have reported a 30-40% reduction in settlement and operational costs since the debut of interoperability by Bats Chi Interoperability in Other International Jurisdictions USA The equities market structure in the US today consists of competing stock exchanges and trading platforms that are required to make market information publicly available on terms that are fair and reasonable, but a single CC and a single CSD serving under common ownership serve the national equities market. While the Cash equity market has a single CC and CSD, the CC of the futures markets continues to be with the exchanges Asia Most of the countries in the Asian region have a single equities exchange, CC and CSD. Korea, Singapore, Hong Kong all have a single equity exchange, CC and CSD. Australia and Japan have alternate trading venues; however they clear and settle through the existing CC and CSD. Pakistan has exchange clearing but a single CSD. China Securities Depository and Clearing Corporation is the central counterparty and guarantees securities and cash settlement for the transactions on both Shanghai and Shenzhen stock exchanges. 1 Predictions For

20 Thus, it is observed that interoperability pre dominantly remains a European phenomenon owing to their fragmented structure, while single CC/exchange CC is the preferred mode in other jurisdictions Interoperability: How it works? /Interoperability models 2 Interoperability facilitates novated trades between market participants that maintain clearing arrangements with different CCPs. To achieve this, a link is established between the two CCPs: the original trade contract is novated at three levels, rather than two as compared to when a trade takes place between participants of the same CCP. The three contracts are between: the buyer and its CCP; the two CCPs; and the seller and its CCP. Accordingly, each CCP provides a guarantee to the other that its side of the trade will be fulfilled; and each CCP provides a guarantee to its participant in relation to the performance of the other CCP

21 Trading venue sends trades to the CCP selected by the Trading Firm Each CCP manages its exposure to the other s inability to fulfill obligations by collateralization If CCP1 is bankrupt, CCP2 will use collateral from CCP1 to cover any losses and expenses involved in closing out CCP1 s obligations to CCP2 and vice versa. Interoperability arrangements are commonly classified according to the symmetry of the risk-management requirements and of the CCPs access to trade feeds. For instance, a CCP link may be set up either as a participant link, or as a peer-to-peer link. A participant link involves one CCP becoming a participant of the other, without a reciprocal arrangement. The participant CCP therefore provides collateral to the other CCP, but not vice versa. To protect itself from a default by the linked CCP, a participant CCP would have to make arrangements for additional default resources from elsewhere. A participant link is more likely to be established 12

22 where the participant CCP has stronger incentives to establish a link than the CCP to which it is linking. A peer-to-peer link involves each CCP becoming a participant of the other, with collateral flowing in both directions (i.e. each linked CCP providing collateral to the other). The CCPs would likely have different participant obligations placed on them than regular participants; this would typically exempt the linked CCP from loss-sharing arrangements with other participants (e.g. contributions to a mutualized default fund), to reduce the direct exposures between each CCP and the other CCP s participants. In view of the foregoing the Committee examined various models for Interoperability/ Single CC and gave its observations: Model I This model envisages that clearing corporations will provide clearing and settlement services to more than one exchange for all their segments. SE1 All segments SE2 All segments CC1 CM1 CM2 SE1 & SE2 - Stock Exchanges CC1 - Clearing Corporation CM1 & CM2 - Clearing members 13

23 The Committee observed that the proposed model is basically a single clearing corporation serving all the exchanges. This model is best suited for optimal utilization of margin and collaterals and will bring about economies of scale. However, the downside of such a configuration is that it will result in a monopolistic structure. Further, the clearing corporation will become a too-big-to-fail market infrastructure institution. Moreover, in equity markets, given the large number of market participants, the challenges to maintain fairness of pricing, reasonable cost of transaction and a non-monopolistic disposition will be difficult to achieve. The potential downside of this model could be addressed by giving the single clearing corporation a public good orientation with sufficient checks and balances. Model II (Part A) This model envisages that the stock exchanges will seek clearing and settlement services of a particular clearing corporation for specific segments, SE1 - Cash Segment SE2 - Cash Segment SE1 F & O Segment SE2 F & O Segment CC1 CC2 CM1 CM2 SE1 & SE2 - Stock Exchanges CC1 & CC2 - Clearing Corporations CM1 & CM2 - Clearing members CM1 CM2 14

24 The Committee observed that the proposed model envisages that stock exchanges will utilize the clearing and settlement services of a particular clearing corporation for specific segments. In other words one clearing corporation will clear only cash segment and all the exchanges will clear their cash segments through that specific clearing corporation. The most noteworthy outcome of this model will be vertical specialization of clearing corporations based on product classes. Model II (Part B) A derivation of the above model may be envisaged wherein the stock exchanges will perform the clearing and settlement of any of their segments through any clearing corporation. However, the option of clearing the same segment through multiple clearing corporations will not be available. Thus effectively, the exchanges have the choice to clear a specific asset class through a particular clearing corporation. SE1 - Cash Segment SE1 Currency Segment SE1 F &O Segment SE2 F &O Segment SE2 - Cash Segment SE2 Currency Segment CC2 CC1 CM2 CM1 CM2 CM1 SE1 & SE2 - Stock Exchanges CC1& CC2 - Clearing Corporations CM1 & CM2 - Clearing members The Committee observed that as per the proposed model, the exchanges have the choice to clear a specific asset class through a particular clearing corporation. However, the 15

25 exchanges will not be able to clear and settle through multiple clearing corporations for a particular asset class. Thus, though this model provides an option to an exchange to choose a clearing corporation, it does not give any flexibility to clearing members to choose the clearing corporation. Thus, the clearing member will have no option but to clear through the clearing corporation decided by the exchange. Hence it will not meet the desired objective. Moreover, in the present scenario, the clearing corporations are owned by the respective exchanges and there appears to be no incentive that would induce the exchanges to opt for other clearing corporations. Model III This model envisages that a stock exchange may tie up with multiple clearing corporations for clearing and settlement of the trades of a particular segment. SE1 - Cash Segment SE2 - Cash Segment SE1 F & O Segment SE2 F & O Segment CC1 CC2 CM1 CM2 CM1 CM2 16

26 SE1 & SE2 - Stock Exchanges CC1 &CC2 - Clearing Corporation CM1 & CM2 - Clearing members The Committee observed that the proposed model is a pure interoperable model. But implementation of the model would require a substantial amount of work, especially to address the risks arising out of interoperability Deliberations by the Committee on single CC and the possible risks arising out of interoperability and inter CC default management The Committee, while weighing the options, namely, the present structure of clearing corporation, interoperability or centralized Clearing Corporation observed that while a single clearing corporation could help bring down margin requirements of market participants considerably, it needs to be considered whether this will come at the cost of putting the entire market at risk, amongst other things. The Committee, upon examining the existing market structure in India, the prevalent risk management systems and interaction with the various market participants deliberated on the possible risks arising in the event of such complete interoperability. It observed that while interoperability is supposed to increase competition, capital efficiency and reduce cost, it also raises concerns about the risk management systems that should be in place to ensure compatibility between the different clearing houses and to contain the additional risks. The Committee noted the risks arising out of links established between CCs (both individual and network of links) 3 as per CPSS-IOSCO recommendations for CCPs. 3 CPSS-IOSCO recommendations for CCPs -November

27 Risks arising out of links established between CCs Risk Risk Event Scenario Effect on Individual Link Counter party Credit Risk- Failure of a Counter Party Liquidity risk - need for additional resources Operational risk-all aspects: additional operational risk for a Sub CCP due to its dependency on the other CCP Legal Risks: Between CCPs Settlement Risks Probability Impact Network Links of Network effect inter-linkages between CCs allow risk to spread. Single point of failure ---- How the CCs manage their exposure to each other s default is at the heart of an interoperability agreement Different options to manage the replacement costs risks between the CCs 4 The Committee also studied the different options to manage the replacement costs risks between the CCs: 4 Paper on "Investigation of risks arising from the emergence of multi -cleared trading platforms"-joint Regulatory Authorities of LCH. Clearnet 18

28 a. CCs require a margin from each other and contribute to each other s default fund In this option, each CC will cover the risk of default of the other CC both in normal and in extreme market circumstances i.e. where initial margin is insufficient to cover losses. However in this option, a CC would be directly impacted by the default of the other in situations where the default fund, including the linked CCs contribution to the default fund, is used. The Contributing CCs may then have to replenish its contributions by calling for further contributions from its own members on the assumption that it would be permitted to assign member default contributions to another CC. This arrangement would require each CC to hold potentially large amounts of collateral with its linked CC which may be inefficient. It is a conservative option and not used today. b. CCs require margin from each other and instead of a contribution to each other s default funds, require from each other the provision of additional resources to cover losses in case of extreme market circumstances. In this case also each CC will hold margin to cover the risk of default of the other CC both in normal and extreme market circumstances. However, the additional resources posted by each CC will not be treated as a default fund contribution by the CC holding the collateral and so cannot be used to meet losses incurred as a result of a default of a clearing member. The difficulty may however be in calibrating adequately these additional resources. If they are too small, these resources could prove insufficient to cover the default risk of the linked CC in stress conditions. If they are too large, the cost of each CC holding potentially large amounts of collateral with the others in the network will be much higher. 19

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